Jonathan Clements Money Guide 2016

Episode: 164
Guest: Jonathan Clements

The Lange Money Hour - Where Smart Money Talks

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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TOPICS COVERED:

  1. Guest Introduction: Jonathan Clements
  2. Happiness
  3. The Safe Withdrawal Rate
  4. Annuities and Equity
  5. Social Security Planning
  6. Active Money Management vs. Buying Index Funds
  7. Portfolio Diversification
  8. The Stock Market

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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.


1. Guest Introduction: Jonathan Clements

Dan Weinberg:  Welcome to The Lange Money Hour.  I’m Dan Weinberg along with CPA and attorney Jim Lange.  Joining us this week is someone who’s been on the program before, and we are just thrilled to have him back, Mr. Jonathan Clements.  Jonathan is one of the country’s foremost experts on personal finance.  He was a columnist for The Wall Street Journal where he worked for almost twenty years.  He also spent six years as director of financial education for City Personal Wealth Management.  These days, he teaches a college course on personal finance, writes a column for Financial Planning magazine and regularly blogs at JonathanClements.com.  Jonathan has written five books on personal finance, including the bestseller, The Little Book of Main Street Money and the newly updated Jonathan Clements Money Guide 2016, which arrived in bookstores just a few weeks ago.  His next book, How to Think About Money, will go on sale in September.  Jim and Jonathan have also collaborated on more than thirty newspaper columns.  Tonight, we’ll be touching on a wide variety of personal finance matters, but specifically, Jim and Jonathan will cover stock market valuations and Wall Street’s rocky start to the year, the new rules for claiming Social Security and the potential death of the stretch IRA.  This promises to be a terrific hour with Jim Lange and Jonathan Clements, so let’s get right to it.  Gentlemen, good evening to you both.

Jim Lange:  Good evening, Jonathan.

Jonathan Clements:  Hey Jim.  It’s great to be with you again!

Jim Lange:  It’s always great to be with you, and I think Dan’s introduction, while it was somewhat complete, doesn’t do you fair justice because I genuinely believe you are one of the top, if not the top, financial writers in the country, and your book…and by the way, for our listeners, if you want one takeaway, don’t even think about it.  If you don’t like it, I will personally refund your money:  Jonathan Clements Money Guide 2016.  I thought your Money Guide 2015 was terrific, but this has a lot of new sections and it’s really good.  So, congratulations on a great accomplishment.

Jonathan Clements:  Yeah, well, thanks a lot, Jim.  It is a huge amount of work to update that book every year, as you know, in addition to all the new information I put in there.  One of the things I do is to make sure the book includes all the latest tax information, all the latest numbers on the market and the economy, and one of the unique things about the book is I update it every year as of December 31st.  I spend my December 31st not drinking champagne, I spend it updating the book.  I send it off to Amazon and Barnes & Noble and, you know, as in years past, it’s available for sale on January 1st.  It’s unlike any other book out there on the market today in that sense.  It is as up-to-date as it can be.

Jim Lange:  Well, I think it is wonderful, and I know that you have the numbers up-to-date and the market up-to-date, but one of the things that I have always appreciated about you and your writing is not just, you know, the Roth IRA, the regular IRA, Social Security (we’ll get into some of that), but some of the things that I’ve always enjoyed about you are some of the, let’s call it, human elements.  Like in the other classic, which I would also recommend to anybody, The Little Book of Main Street Money, you talk about the joy of buying experiences, not things.  And then you came up with a couple true gems in the Jonathan Clements Money Guide 2016, and one of those was actually about happiness.  So, can we talk about happiness for a few minutes?


2. Happiness

Jonathan Clements:  Yeah, the relationship between money and happiness, Jim, is one of the things that has been a big focus for me over the past decade.  For those who aren’t aware of it, the connection between money and happiness has been a source of intense academic research over the past twenty years or so.  One of the things that we know about money and happiness is that there’s ample evidence that, contrary to what we all believe, money tends not to buy a lot of happiness.  You go back forty years ago, the standard of living in the United States was half of what it is today.  And yet, the reported level of happiness forty years ago was actually no lower than it is today.  In other words, despite the fact that we’ve doubled our income over the last forty years, we aren’t any happier.  Money hasn’t bought happiness.  And it isn’t that money can’t buy happiness, it seems that people use their money in the wrong way.  So, Jim mentioned one of the key findings in the research, which is that we tend to get more happiness from our dollars if we spend it on experience rather than things.  Suppose you have a choice between buying a new car or taking the family on a trip to Paris.  The new car might seem like a great purchase.  It’s got lasting value.  You’ll get to use it for many years, and so on.  By contrast, if you go to Paris, the trip’s going to be over and the money’s going to be gone, and yet, because of the very nature of the trip to Paris, that it’s over and done with, that tends to be why it delivers greater happiness.  Not only do we have the anticipation beforehand, but we also have months, even years, of great memories afterwards, and if anything, those memories become better over time as we forget the incidental annoyances and we just think about the good moments.  By contrast, with a brand new car, we have to sit there and watch it deteriorate over time.  So, as happy as we are when we first buy the car, a couple years down the road, it’s likely to become an increasing source of unhappiness as we have fender benders, as the car breaks down, we got the big repair bills, and so on.  So, one of the big lessons from the research on money and happiness is if you’re going to spend your dollars on anything, spend it on experiences, not things.

Jim Lange:  Well, I think that’s great advice, and something I learned from my own father-in-law.  Every year, he finances a family get together.  So, the family right now on my wife’s side is spread throughout the country, and every year, with his own dollars, my father-in-law organizes a family get together.  No matter where you live, if you live close, you can drive, if you live far, you can fly on his dime, and for about four or five days, we stay at a, I won’t say very fancy, but a pretty nice resort that has everything, like tennis and hiking and golf, and you do whatever you want to do.  His only rules is that we eat together.  He finances the whole thing, and in a way, you could say, “Well, geez, he’s kind of spending Jim’s wife’s inheritance,” but really, I think he’s getting really lasting value because the cousins grow up knowing each other, and he’s creating these wonderful family experiences for people.  So, I think that that’s so profound to buy experiences.

The other thing that you said, which I thought was very interesting, was that yes, of course, if you’re poor, you’re not going to be so happy, but it’s kind of like diminishing returns.  But it’s still good to live relatively frugally in order to not have money worries, because money worries are the cause of unhappiness.  Could you expand on that idea?  Because I thought that was really profound, and frankly, hits my own life a little bit because sometimes entrepreneurs, even though we sometimes are trying to make a fair amount of money, we have ups and downs when we worry that we don’t even have enough money to cover payroll, which causes great anxiety.  So, I thought that was a great thought.  Could you expand on that, please?

Jonathan Clements:  Sure.  There’s a number of different aspects to this, Jim, that are worth thinking about.  I mean, first of all, the story, the famous book, The Millionaire Next Door, that was the bestseller that came out in 1996 and talked about these everyday millionaires in America and what was the defining characteristic of these millionaires, and the number one defining characteristics of the millionaire next door was their frugality.  The reason that these people ended up being rich was because they had great savings habits.  The Millionaire Next Door is the couple who live in the modest home, they drive the secondhand car, they don’t wear designer clothes, and because they live far beneath their means, they’re able to save great gobs of money.  But if this is simply by living beneath your means, you can save a huge amount every month, you also (as you rightly suggest, Jim) reduce the financial stress in your life.  If you’re worrying every day about how you’re going to pay the bills, you’re not going to enjoy your day-to-day existence.  But if you live comfortably within your means, then yes, you will have far less financial worries and you can focus on enjoying your life.  One of the rules of thumb that I use with people is I say, “If you possibly can, try to keep your fixed living costs,” and what I mean is things like mortgage or rent, car payments, insurance premiums, groceries, utilities, stuff like that, “try to keep those fixed monthly costs at less than fifty percent of your pre-tax income.”  If you do that, you keep your fixed living costs below fifty percent of your pre-tax income, not only will you be able to save a lot of money every month, but also, you’ll have a fair amount of discretionary income.  This is income that you can use for whatever takes your fancy, and thus you can use that money to have those great experiences, to have the great vacation, to bring the family together for a special meal, whatever it is.  So, keep your fixed costs low, you’ll reduce your financial stress, you’ll be able to save lots of money every month, plus you’ll have the extra cash for those fun family experiences.

Jim Lange:  Well, I think that that’s some great advice, and one of the things that a lot of listeners do, and particularly young listeners, is they will buy the most expensive house that the mortgage broker says that they think they can afford, and they might go up to sixty or sixty-six percent of their, in effect, disposable income that is going towards fixed costs.  And you’re actually advocating perhaps a smaller home in a not quite as prestigious street in order to have more money to spend on whatever you want.  Is that correct?

Jonathan Clements:  That’s absolutely correct, Jim, and there’s sort of an additional point here that is worth keeping in mind, which is if you get out of college in your twenties and you go out and you lease that luxury car that you always wanted to have but that you can barely afford or you go out and you buy the most expensive house that you can buy, well, not only do you put yourself in a financial hole, but also you’re going to get used to that lifestyle.  If you’re driving a BMW in your twenties, what do you have to look forward to when it comes to driving vehicles in your fifties?  I mean, if anything, by the time you get to your fifties, you’ll have been spending so much money on cars that actually you’ll have to go and drive a Honda Civic in order to start saving enough for retirement.  What you want to do is design a life for yourself where you enjoy a gradually rising standard of living, because then you’ll really appreciate that gradually rising standard of living.  If you start out flying in first class, it’s never going to seem that special, and it’s going to seem really grim when you end up in economy later in life because that’s all you can afford.  But if you start out in economy, when you can finally afford to start flying first class when you’re in your fifties and sixties, it really is going to seem special.

Jim Lange:  Well, I think that that’s great advice, and by the way, it actually sounds very similar to advice by a guy named Jim Dahle, who wrote a book called The White Coat Investors, and he’s telling interns and residents the same idea: don’t start spending a lot of money as soon as you start making it, but rather, bank it, keep your costs down and be able to accumulate money so you can enjoy more of the money later.  But one of the things that that relates to, which I actually think is one of the most important concepts in finances, is the safe withdrawal rate.  And by the way, you do a great job laying out all the basics in your appendix, apparently the result of your teaching, and we’re talking about the appendix in your new book, The Jonathan Clements Money Guide 2016, which I’ve made a special offer to our listeners that I’m recommending everybody buy it.  Don’t even think about it.  If you don’t like it, I’ll refund your money personally.  But anyway, so you defined the term, but if you could give us some of your thoughts on what is commonly known as the safe withdrawal rate, how much money measured as a percentage of your portfolio can you safely spend in retirement.


3. The Safe Withdrawal Rate

Jonathan Clements:  This has been a matter of a lot of debate.  As you well know, Jim, and as I’m sure you’ve discussed on previous shows, if you go back to…

Jim Lange:  We had Bill Bengen himself on.

Jonathan Clements:  Well, I was going to say if you go back to the early 1990s, there was this financial planner from California called Bill Bengen, who wrote this article for the Journal of Financial Planning talking about this four percent withdrawal rate, and what Bill found in that study was that if you’re looking at potentially a thirty-year retirement and, you know, you have to anticipate that the markets could do all kinds of crazy things (the stock market might go up, it might go down, you just don’t know), but if you look historically at what has happened with the financial markets, and you also figure in the rising income you’re going to need because of inflation, that the maximum that you can withdraw in the first year of retirement was about four percent of your portfolio’s value.  So, if you retired with $500,000, in the first year of retirement, you could pull out $20,000, and then you can increase that $20,000 every year along with inflation, and if you did that, historically, no matter how bad the market’s got, you would have made it through a thirty-year retirement without running out of money.  So, that’s what the four percent withdrawal rate is.

Now, since then, the four percent withdrawal rate has been analyzed this way and that.  In recent years, it’s been questioned, and people are saying that now that interest rates are so low, and now that stock market valuations are so high, that maybe the withdrawal rate should be lower than four percent.  And my response is this: yes, you may indeed be right.  Maybe four percent is too much.  But frankly, you know, it can’t be too much lower than four percent or all of America is not going to be able to retire.  It’s simply not going to be enough money.  So, don’t just tell me I’ve got to withdraw three percent and that’s it.  That’s not helping me.  What you need to tell me is what’s the strategy that I can use to get a decent amount of income off of my portfolio based on what I have, and I think there are a number of financial tools available to people heading into retirement that they can use in order to have a decent amount of income generated by their savings.  Two particular tools come to mind: one is, you know, you might start with a four percent withdrawal rate.  You might even start with a five percent withdrawal rate, but if the markets go against you, if we get a big drop in the stock market, or if bond returns are really terrible, you have to stand ready to severely cut back your spending in the short-term so that you don’t end up with that double dipping into your portfolio where not only the market’s reducing the amount of your savings, but also you yourself are pulling money out of that portfolio, and that double hit is really decimating your portfolio’s value.  So, sure, start out spending four or even five percent, but if the markets turn against you, cut back your withdrawals, cut back your spending temporarily so you limit the damage.

The second strategy, and this may segue into one of the topics we wanted to talk about, Jim, is what you should seriously consider doing is using your savings to cover all of your costs in the early retirement years while delaying Social Security, so that you get a bigger check from the government.  If you delay claiming Social Security from age 62 (which is the earliest possible age) to age 70 (which is the latest possible age), you will get a real after inflation increase in your monthly check by 76% or 77%, and for a lot of people, that larger monthly check will make for a much more comfortable retirement while also providing them with a safety net if they live far longer than they ever imagined.

Jim Lange:  Well, that is a great segue to Social Security, but there’s two more strategies that you have recommended in the past that I don’t want to not talk about, and that was the concept of immediate annuities and then the potential either borrowing money on your house, or if not technically a reverse mortgage, the idea of, in effect, spending some of the equity in your house before you sell it or die.


4. Annuities and Equity

Jonathan Clements:  So, let’s take each of those in turn.  First, immediate fixed annuities.  I think immediate fixed annuities are a pretty good product.  If you said to me, “Should I buy an immediate fixed annuity?” the first thing I would say to you is, “The best annuity you can get is delayed Social Security payments.”  If you’re inclined to buy an annuity before you make that purchase, make sure you’re delaying Social Security to get that maximum possible check.  That’s the number one strategy.  If you do that and you still want more lifetime income, at that point, look into claiming and look into buying an immediate fixed annuity.  But an immediate fixed annuity is never going to be as good a deal as Social Security, and the simple reason is this: Social Security benefits are designed to be actuarially fair to the retiree population based on the entire U.S. population.  So, we’re talking about the typical life expectancy for Americans aged sixty and up.  When you buy an immediate fixed annuity, the insurance company isn’t pricing it based on the broad U.S. population.  Instead, it’s pricing that annuity based on the healthy, affluent individuals who tend to buy immediate annuities.  So, the pricing is not as generous as it is for Social Security, and hence, you shouldn’t buy an immediate fixed annuity unless you first delay claiming Social Security.

Jim Lange:  I would agree with that, and then what about your idea that we’ve actually written a column about, about potentially using the equity in your home, and not even necessarily doing it, but having that as a backstop.

Jonathan Clements:  You can think about tapping into your home equity as a two-step process.  The first thing that people should think about doing as they reach retirement age is trading down to a smaller home.  At that point, the kids are gone.  You may not need as large a home.  So, you should trade down to a smaller home.  That will free up home equity that you can then add to your retirement savings.  Plus, with any luck, it’ll also reduce your monthly costs, which will give you extra cash to spend through retirement.  Once you’ve done that, if you need additional money from your house, you can indeed look into doing a reverse mortgage.  But I would see the reverse mortgage as not a first step, but more of a last resort.

Jim Lange:  I would agree with everything that you have said.  So, why don’t we take a break, and we’ll come back and talk about Social Security?  Because I know that you’re anxious to, and, as you know, I’ve written a new book on it, and I would love to talk about it.  But we are talking with Jonathan Clements, who is the author of The Jonathan Clements Money Guide 2016, which I’m recommending all our listeners, both the local and our internet listeners, purchase.  So Jonathan, you started talking about Social Security and the enormous difference between getting the Social Security strategies right and getting them wrong, which the vast majority of married couples do.  And I wanted to talk a little bit about the idea that, in effect, it’s practically impossible…in fact, I would say it is impossible, to get a safer investment than holding up on Social Security.  So, not only do I usually like the idea of waiting on when to collect your Social Security, I also like some of the marital concepts like apply and suspend, claim now, claim more later, which is also known as filing a restricted application.  Well, why don’t we start with some of the basics?  What is the incentive for people to hold off on their Social Security, particularly if people don’t have a tremendous amount of confidence in our government right now, whether it’s the president or the Congress, and they are fearful that Social Security will either be reduced or means tested?


5. Social Security Planning

Jonathan Clements:  Well, that’s a great question, Jim.  So, when I talk about Social Security, I emphasize some of the great attributes that Social Security has.  To wit, you get it every year for the rest of your life, it increases every year with inflation, it’s at least partially tax-free, it’s government guaranteed, and if you die, potentially your spouse could receive your benefit as a survivor benefit.  I know there are a lot of people out there who say, so I get these e-mails all the time saying, “I’m claiming Social Security at age 62 because I want to get the money from the system, any money I can, before they cut Social Security.”  Go and look at the proposals from the presidential candidates.  To the extent that the presidential candidates are talking about changing Social Security, any changes will apply to those who are 55 or younger.  Nobody is talking about cutting Social Security benefits for existing retirees.  And the fact is, if that happened, any politician who voted for it would be out of office at the next election.  I mean, we saw this back in the early 2000s when the Bush administration considered privatizing or partially privatizing Social Security.  There was a huge backlash against the idea.  People will not stand for Social Security to be cut.  It is political suicide.  It’s not going to happen, and it’s a terrible reason to claim Social Security at age 62.  I presume you agree with me here, Jim?

Jim Lange:  Oh, I agree completely.  In fact, I’m a big fan of holding off until both members, if you have, let’s say, a couple who are 66, I want the primary wage earner to hold off until 70, and then the spouse to take a spousal benefit when they’re 66.  Ideally, they will do the apply and suspend, which is going away on April 29th, 2016, so I’ll put in a little plug for my own book, The Little Black Book of Social Security Secrets.  The best techniques for Social Security are actually going to be eliminated, and you can, if you’re born in the right years, grandfather yourself, and again, it’s about forty pages, less than 10,000 words, some important graphs, but you can get that Social Security book by going to www.paytaxeslater.com/ss.  Sorry, Jonathan.  Usually, I plug your book, but I just thought I would plug mine.

Jonathan Clements:  No, Jim, it’s a really important topic, and, as you suggest, there’s a very small window of opportunity.  So, for people who are coming to this subject new, there are two crucial changes that were passed as part of the 2015 budget act.  It’s a little bit complicated, but I’ll try to explain it in plain English.  Essentially, until that budget act was passed, people were allowed to do two things: one, they could suspend their Social Security benefit once they reached their full Social Security retirement age, which is typically 66 or 67, and even if they suspended their benefit, people who are receiving benefits based on them as the primary breadwinner, they could continue to receive those benefits.  The second big thing that changed was it used to be that everybody was allowed to file a so-called restricted application once they reached their full Social Security retirement age, and what that meant was that if you reach your full Social Security retirement age of 66 or 67, you could say, “No, I don’t want the benefit based on the earnings I had during my lifetime.  Instead, I want to apply just for spousal benefits.”  So, as a consequence of these two provisions, what would often happen (it was the smart strategy) was the main breadwinner would file for Social Security at his or her full Social Security retirement age of 66 or 67.  That allowed his or her husband or wife to claim spousal benefits.  The main breadwinner then suspended benefits through until age 70 to get the largest possible benefit, and then, meanwhile, the spouse collected spousal benefits for a few years, and once he or she reached 70, they could potentially convert over and get their benefit based on the delayed retirement credits that increased their benefit.  Both these things are going away, but slowly.  So, people who reached age 62 by January 1st of this year are still able to file that restricted application.  Meanwhile, as you mentioned, Jim, as of April 29th, the ability to suspend benefits and still have people collect based under your benefit is going to go away.  So, people have this small window where they can still apply and suspend for benefits before April 29th, and that could open up the chance for their spouse to collect four years of spousal benefits even while their own benefit is growing, and that could be worth $40,000-$50,000 to many families.

Jim Lange:  Well, and over time, in my book, I have a case study where I show a husband and wife both taking their own benefit at 62 versus doing the apply and suspend…actually a combination of apply and suspend at a restricted application, and, of course, you know me, I can’t help myself, a series of Roth IRA conversions based on the lower tax bracket, which I actually believe is a synergistic combination.  The difference, over time, was over two million dollars.  So, that is one couple who runs out of money, and, towards the end of their life, the other couple has two million dollars.  Same earnings, same investments, same everything.  It’s just a different Social Security strategy, although I threw Roth in there.  But even just Social Security strategy, it could be a million dollars.  You made a very good point in your book that is hard for people to understand, which is…let’s say that people are 62 or even 66 for that matter, and let’s say that they don’t have any other income.  That is, they don’t have a pension.  They are not working.  So, their choice is either collect Social Security, which will forever doom them to a lower amount, or eat into their portfolio, and let’s even use the worst case situation when their entire portfolio is IRA or retirement plan, and they actually have a pay income taxes.  So, they have to withdraw, let’s say, $1.40 to pay $1.00.  Would you still have them withdraw money from their portfolio rather than go into their Social Security earlier?

Jonathan Clements:  The answer is yes, Jim, and let me just break it down two different ways: first of all, for people who were confused about this whole discussion about apply and suspend and restricted applications and so on, I think just two takeaways that people should have from this conversation are one, if you are in your sixties and you’ve reached your full Social Security retirement age, if you haven’t yet claimed Social Security, or even if you have, you should talk to an expert on Social Security, or indeed, get Jim’s free book, and address this topic before April 29th of this year because it is a very small window of opportunity.  And two, a more general principle that everybody should keep in mind is whether you are married or single, but especially if you’re married, your number one instinct should be for the main breadwinner, or the single individual, to delay Social Security through until age 70 to get the larger monthly check, and that larger monthly check will salvage your retirement, and if you’re married and you hold out for that larger monthly check, even if you’re in poor health, your spouse will receive that larger monthly check as a survivor benefit.  It’s worth delaying until age 70, even if your health isn’t good, if you’re married.

So, having mentioned those two key takeaways, coming back to the question of should you use even a retirement account, which would trigger income taxes, to cover your early retirement years while you delay Social Security through until age 70?  Based on just that information, I would say absolutely, and the reason is this: a lot of people do the reverse.  They go through their sixties, they claim Social Security early, they run down all the money in their taxable accounts and they don’t touch their retirement accounts.  They just leave them to grow until they reach age 70 ½, at which point, they’re required by law to start taking those minimum distributions from their retirement accounts.  As a consequence of doing that, what a lot of retirees discover is they pay relatively little in taxes through their sixties, which is a wasted opportunity, and then they get to their seventies and they suddenly find they’re paying massive amounts of income taxes because they have to make these large retirement account withdrawals, and not only do they have these large retirement account withdrawals that are taxable, but because of that additional income, they trigger taxes on up to 85% of their Social Security benefit.  This is something that the tax experts call the ‘tax torpedo.’  If you don’t know what it is, just stick those two words in a search engine and look it up: the tax torpedo.  It’s a terrible tax dilemma that people can get into if they’re not smart about how they handle Social Security and how they handle those retirement account withdrawals through their early retirement years.


6. Active Money Management vs. Buying Index Funds

Jim Lange:  So Jonathan, one of the questions that a lot of listeners have, or maybe they’re not even thinking to ask these questions, but you’ve been talking about this for years, is the difference between active money management, either with a money manager or even you yourself picking different stocks versus buying a broad-based  index fund.  Could you talk to our listeners a little bit about this?  Because I think that you did a very good job discussing this in your book, the Jonathan Clements Money Guide 2016.

Jonathan Clements:  So, the case for indexing, Jim, is really very simple.  We, as investors, collectively earn the results of the broad market before costs.  Before costs, we collectively earn the performance of the broad market.  After costs, we all must collectively earn less, and in fact, we will collectively trail the market averages by an amount equal to the investment costs we occur.  To the typical investor in actively managed mutual funds, that’s going to turn out to be about two percentage points a year.  So, if the market returns eight, owners of actively managed funds will collectively earn six.  Now, some lucky few will manage to beat the market in any given year, but most will not.  By contrast, with an index fund, you give up all chance of beating the market, but you know that you’re going to beat most of your fellow investors, and the reason is simple: while they’re collecting the market minus two percentage points or so on average, with an index fund, you can collect the market’s performance minus something like 0.06% per year.  So, you pretty much get the market’s result while everybody else is going, on average, to be lagging far behind.  Now, you might say to yourself, “Well, I think I’m a smart guy.  I can beat the market even if most people can’t.  I can find the right actively managed funds.  I can pick the right individual stocks.”  Yes, you might be able to do that this year.  You might even be able to do it next year.  But trust me, you are not going to do it over a lifetime of investing.  As I like to tell people, there’s a reason we talk about Warren Buffett over and over again, about his record of beating the market over fifty years, and the reason we talk ad nauseam about Warren Buffett is because he’s the only one.  I don’t know of anybody else with a verifiable record of outperforming the market averages over fifty years.  We talk about Warren Buffett because he is the only one.  Everybody else is lagging behind the market.  If you think you’re really lucky, by all means, roll the dice and try to beat the market.  But history tells us and the odds tell us that you will most likely fail.  Meanwhile, for those of us who own index funds, we will collect the market’s result and we will have a far greater chance of retiring in comfort.

Jim Lange:  Well, let’s talk a little bit about index funds, and let’s even assume that index funds are an excellent way to go.  I see this scenario very, very typically when I analyze a prospect’s portfolio.  So, when somebody comes to me and they are interested in having money managed, we review their portfolio.  And as you know, for virtually all new clients, we are using index funds.  We happen to use DFA funds, which you actually mentioned in your book pretty favorably, but they have a different asset allocation recommendation than most people that come in.  So, most prospects that come in, when I look at their portfolios and I analyze them just on an asset allocation basis, I usually find the vast majority of their stock investments are in very, very large U.S. companies, and I was wondering if you could talk about some of the alternatives to large…and not only U.S. companies, but large growth companies?  Companies that, frankly, we have all heard of and that we are comfortable with because we know what they do.  But that is to the exclusion of both smaller companies, value companies and international companies.  So, could you talk a little bit about a well-diversified portfolio and why that is so important?


7. Portfolio Diversification

Jonathan Clements:  So, as you well know, Jim, there have been, over the last thirty years or so, thirty-five years now, two really seminal pieces of academic research.  You go back to 1981, and there was a researcher at Northwestern University called Ralph Barnes, who wrote a seminal article about small company stocks, and what he found was that small company stocks performed not only better than large company stocks, but better than large company stocks even after adjusting for risk.  So, one of the things that a lot of money managers do, who pay attention to the academic research, is to tilt their portfolios slightly more heavily towards small company stocks.  So, they have more in small company stocks than you would normally have if you were just following a market weighting.  And the second piece of seminal academic research came out in 1992, and it was produced by a couple of academics called Eugene Fama and Kenneth French, and what they found was that not only did small company stocks do better than you would think based on conventional measures of risk, but so too did something called value stocks, and value stocks are essentially the ugly stocks of the market.  These are the stocks that tend to trade with high dividend yields and low price-to-earnings ratios and low price-to-book value.  These are stocks that have been beaten down, and what French and Fama found was that these stocks tended to perform better than you would think if you based on measures of risk.  So, what a lot of money managers now do, who are influenced by the academic research, is they tilt towards small stocks and they tilt towards value stocks, and by doing so, you’re not guaranteed to beat the market this year or next year, but there is an expectation that, over longer periods, you will do better than the broad market averages.  But, and this is a big but, and people need to keep it in mind, there is a reason that you get outperformance.  The only way you can get outperformance is to take risk.  So, there’s something about these small stocks and these value stocks, something about them that, you know, they have a riskiness that’s not getting captured by conventional measures of risk.  It may be that these companies are more financially fragile.  There’s a greater chance that they will end up in bankruptcy.  There’s a greater chance that they will do really poorly if we have a bad recession.  So, you are, in some sense, taking more risk if you tilt towards small and you tilt towards value, but if you’re willing to take that risk, history tells us that you should get better performance from the broad market averages over time.

Jim Lange:  And then what about international?  And by the way, that is the approach that…you know, French and Fama are still at DFA, and they would argue that you actually have a safer portfolio because you are more broadly diversified.  But how would international play in on that?  Because so many people are saying, “Oh, China’s going down the tubes.  You know, the U.S. is the best place in the world to invest money.  Why should I invest anywhere other than the U.S.?”

Jonathan Clements:  So, Jim, to my mind, tilting towards small and tilting towards value is a story about taking somewhat more risk in hopes of getting a somewhat greater return.  Putting money into foreign stocks is really, to my mind, a diversification story.  There have been plenty of years when the U.S. market has done poorly and foreign stocks have done reasonably well.  If you invest solely in U.S. stocks, you could go through a long period, five or ten years, where you have mediocre returns while the foreign markets do very well.  By including foreign stocks in your portfolio, you can help to insure that you’ll get reasonable returns over a five- or ten-year period no matter which market does well because, thanks to your diversification, you have all of these markets within your portfolio.

Jim Lange:  All right.  We are here with Jonathan Clements.  We only have a few minutes left, but Jonathan is the author of the Jonathan Clements’ Money Guide 2016, that I highly recommend, and Jonathan, I’m going to give you a choice with the last, maybe, two or three minutes, to either talk about anything that we haven’t talked about that you want to talk about, or you do have a very good discussion of the different types of insurance that people should have.  So, I’ll give you a choice of anything that we haven’t discussed or insurance, and we have about two minutes left.


8. The Stock Market

Jonathan Clements:  Well, I think, Jim, that maybe we should just talk very briefly about a topic that’s on a lot of people’s minds, which is what the heck is going on with the stock market right now?  You know, we’ve had a really bumpy start to the year.  I’ve been getting the e-mails.  I’m sure you’re getting the e-mails.  A lot of people are concerned.  They’re like, “What’s going on here?”  And the answer is really very simple, which is investors collectively are trying to figure out what’s going on with the economy.  We’ve had signs that economic growth may not be that great, the fourth quarter GDP number was not great, the latest number for job growth for January was not great, and people are looking at those numbers and saying, “Are we headed to a recession?  Are we going to see an economic slowdown?  If we have slower economic growth, it means we’re going to have slow growth in corporate profits.  If we have slow growth in corporate profits, then maybe stocks are overvalued, and that’s why we have the market down over ten percent.”  What I would say to investors is whatever you’ve been doing up to now in terms of regularly adding to your portfolio, contributing to your 401(k), you should keep on doing that.  If you’re an investor and share prices go down, you should become more enthused, not less.  That said, I don’t think that we are anywhere near the point where you should start backing up the truck and buying stocks like crazy because they’re at bargain prices, because they are not.  Stocks are richly valued.  I do think that if you hold stocks for ten years, you will do just fine.  But this is not like it was back in March, 2009 when the market was down 57%, and we really did have great valuations.  This is still a relatively expensive stock market, so people should proceed with caution.

Jim Lange:  Great advice from Jonathan Clements of the Jonathan Clements Money Guide 2016.  I thank you so much for being on the show, and I will also put in a final plug for my own Social Security book that we are offering for free by going to www.paytaxeslater.com/ss.  Thank you again, Jonathan.

Jonathan Clements:  My pleasure, Jim.

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